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The market's Red October nailed the coffin on one of the most trusted trading strategies of the bull market — and …

6 Nov 2018

The longest bull run in the stock market’s history is showing more signs of its age.

The market action around last month’s sell-off — dubbed Red October, because it was the worst drawdown in seven years — demonstrated that stocks are not recovering from such downfalls as briskly as they used to.

Months before the market registered its historic bull streak earlier in 2018, Bank of America Merrill Lynch strategists flagged that the so-called strategy of buying the dip was not working like it used to.

The October sell-off corroborated this assertion, according to strategists at Morgan Stanley.

“October was not just a technical sell-off like the one in February,” Michael Wilson, the firm’s chief US equity strategist, said in a client note.

“We now have fundamental drivers: higher interest rates, slowing economic growth next year, margin risk, and tighter financial conditions,” he said. “They all add up to investors holding less risk and, without incremental money flows, this new primary downtrend will likely take time to reverse.”

In other words, there are now serious downside catalysts that make it harder for investors to pour their cash back into stocks after downturns, leaving the market more vulnerable in such moments. Chief among these stimuli in October was the persistent rise in interest rates, which, according to Wilson, put stocks in overvalued territory for the first time since January.

To prove the demise of dip buying, Morgan Stanley ran the numbers on the S&P 500‘s average daily performance if the prior week’s return had been negative. The ideal scenario for a trader who buys at the low of a weekly decline is a subsequent rally.

However, this outcome has not been the case in 2018. As the chart below shows, based on these parameters, buying the dip has experienced its worst track record since the early 2000s.

Morgan Stanley

Wilson is not forecasting that investors will no longer buy dips, nor is he recommending that they stop the practice. After all, buying stocks consistently without regard for their price is a smart way for long-term investors to lower their cost of trading over time — a practice referred to as dollar-cost averaging.

He is saying, however, that investors should henceforth brace for more volatility as stocks attempt to recover from their losses.

Wilson saw the October slump as a manifestation of the rolling-bear-market thesis he had espoused for more than a year prior. The rolling bear market is now morphing into a “chopping” bear market, he said, characterized by wilder swings and smaller rallies. Besides higher interest rates, investors are worrying about rising labor costs and how this might eat into corporate profits next year, and the shrinking balance sheets of the world’s biggest central banks.

“For the rest of the year, we think US equity markets are likely to remain very choppy but in a narrower range,” Wilson said.

“In terms of the S&P 500, we think the wider range of 2400-3000 we posited at the beginning of the year has likely narrowed to something like 2650-2800 — but with bigger intraday swings and hard-to-anticipate price action.”